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Utilities ETF: Importance of Diversity

ETFs are good way to own the utilities sector. Utilities are prized for their stability, regular cash dividends, and tendency to reduce portfolio beta. Unfortunately in some instances individual utilities have not been as stable as their reputation suggests. ETFs solve this problem by reducing concentration in individual companies. Diversification helps achieve stability.When Japans earthquake damaged its nuclear operations, utilities worldwide sold off in sympathy with Tokyo power generator TEPCO. Hardest hit were utilities with nuclear assets, like Entergy (NYSEArca:ETR - News) and Exelon (NYSEArca:EXC - News). Although both of these companies are held in utilities ETFs, the diversity of the ETF structure minimized losses for investors. The chart below shows the performance of a utilities ETF, the iShares Dow Jones U.S. Utilities (NYSEArca:IDU - News), Entergy and Exelon in the days following the nuclear disaster in Japan.

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EXC is IDUs second largest holding, comprising over 5% of the fund. ETR is not in IDU's top ten holdings. Though diversity and protection is inherent in the ETF structure, the goals of most utility investors (stability and regular dividends) are particularly well suited to ETFs. Not since California electricity crisis of 2000-2001 when utilities were forced to buy power on the spot market has there been so precipitous move in utilities stock. Then, as now, investors with a portfolio concentrated in impacted companies suffered.Utilities belong in every portfolio but investors may want to underweight or overweight the sector depending on the three most important factors influencing the price of utilities: politics, and the market cycle, interest rates. During most of the Bush era, utilities outperformed every sector other than oil. Utilities investors benefitted from 1) a regulatory-friendly administration 2) broad domestic market stagnation outside of energy 3) declining long bond yields. New regulation hurts profitability. Strong markets make utilities less profitable on a relative basis. Declining bond yields make the dividends utilities pay relatively more attractive.On regulation: nuclear utilities after Japans earthquake may face new regulation, but demand for electricity is stable. The power generated by nuclear plants is difficult to replace. Even if few new nuclear plants are built domestically (China allegedly has plans to build over 200 plants) all but a very few existing plants nuclear plants will probably have their licenses renewed. Market demand for carbon-free emissions is also intense.On market direction: Utilities tend to underperform in the early and middle stages of a bull market. They outperform in the later stages of a bull market and in a cyclical bear market. The bull market began March of 2009. The chart below compares IDU with the Standard and Poors Depositary Receipts (NYSEArca:SPY - News) on a three year basis.

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Because they are de facto monopolies, utilities are regulated. They are allowed a profitbut not too much profit. In times of market expansion, this regulation slows profit growth. In comparison with the less regulated sectors, utilities underperform. But as the chart shows, in times of market contraction, investors tend to be glad to get utilities reliability.On bond yields: Because they compete with U.S. treasury bonds for yield, utilities ETFs tend to be sensitive to interest rate changes. During most of the Bush era, utilities ETFs paid yields lower than the 10-year treasury note. With treasuries currently near their all-time highs, yields have fallen below 3.5%. Utilities ETFs yields tend to be around 4%. This means that they currently yield more than treasuries. While the current environment of very low treasury yields is a good reason to prefer utilities ETFs, the potential for inflation or higher treasury yields in the coming months represents perhaps the biggest risk to utilities ETFs.A list of utilities ETFs and their expense ratios follows:DOMESTICUtilities Select Sector SPDR (NYSEArca:XLU - News), annual fees: 0.20%Vanguard Utilities ETF (NYSEArca:VPU - News), annual fees: 0.24%iShares Dow Jones U.S. Utilities Sector Index Fund (NYSEArca:IDU - News), annual fees: 0.48%INTERNATIONALiShares S&P Global Utilities Index Sector Fund (NYSEArca:JXI - News), annual fees:0.48%Wisdom Tree's Utilities Sector Fund (NYSEArca:DBU - News), annual fees:0.58%STRATEGYPowerShares Dynamic Utilities Portfolio (NYSEArca:PUI - News), annual fees:0.63%First Trust AlphaDEX Fund (NYSEArca:FXU - News), annual fees: 0.70%LEVERAGE/SHORTUltra Utilities ProShares ETF (NYSEArca:UPW - News), annual fees:0.95%Ultra Short ProShares Utilities ETF (NYSEArca:SDP - News), annual fees:0.95%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.